April 2018

First Quarter 2018

Exuberant Volatility

During all of 2017 we never saw real volatility in the stock market. That has not been the case for 2018. What started off as a lamb has turned into a roaring lion. On one day we saw the Dow Jones Industrial Average lose 500 points during the day, only to rebound in the late afternoon, with a 200-point gain for the day. That is a definition of volatility. If big swings only happened on one trading day it would not be a big issue, but this is happening on many trading days.

In 2017 the market was driven, for most of the year, by the hope that the Federal Government would change the tax law to be more favorable to corporations. This year the market is being driven by the fear of a global trade war, and especially a trade war between China and the U.S.

Let’s look at the numbers for the first quarter of the year. The quarter began with the S&P 500 at 2674. It ended the quarter at 2641, with a loss of 33 points or -1.2%. The mid-cap stocks, represented by the S&P MidCap 400 began the year at 1901, ending the quarter at 1879 for a loss of 22 points or -1.2%. Small stocks, represented by the S&P SmallCap 600, began the year at 936 and ended at 938 for a gain of 2 points or 0.2%. International markets, represented by the DJ Global ex US index, began the year at 267 and ended the quarter at 262 for a loss of 5 points or -1.9%. Interest on the 10-year Treasury Note rose from 2.409 to 2.741 for a negative return of 0.33%. The Bloomberg Barclays USS Aggregate Bond Index went from a yield of 2.97 at the beginning of the year to 3.13 at year end, giving a negative return of 0.16%.

What do the Numbers Tell Us?

The above information tells us there was no place to hide from the downturn in prices in stocks and bonds during the first quarter. The DJ Commodity index was up less than 1% and the30-year mortgage rate (fixed) went from 3.92 to 4.40. The Fed raised the interest rate another 0.25 in March and wondered about inflation. With all the talk about Gold during the quarter, the price of gold was only up 0.13%. I believe in non-correlated assets. Those are assets that do not move in lock step with other assets. For example: U.S. large, mid and small stocks are highly correlated vs. U.S. Bonds that are only slightly correlated with U.S. stocks.

When you look at the list of assets I’ve described above many of these asset classes are not correlated well with each other but they all did poorly or went down during the first quarter. We have seen this happen before, but it is unusual.

Diversification and the End Game

As investors we enjoy periods like 2017 where there was little volatility and most asset classes did well. Most of the time this is not what we get. We find some asset classes are doing better than other asset classes or, like now, no asset class seems to be doing well. Diversification is still the answer. It helps to reduce the risk of putting all your investments in one asset class that may or may not do well. It tends to smooth out the results in your portfolio over the years, as leading asset classes will tend to change from year to year. The end game is to diversify and understand that over the short run markets go up and down. Based on the past you want to be a long-term investor, not one looking at daily or monthly market swings.

Trade War!

Trade wars have been shown not to be good for the economy. There will likely be winners and losers, but it is difficult to figure it out until some damage has been done. Going back some years ago the Russians and Japanese had massive fishing trawlers and fish processing ships off the coasts of the United States. At the time the U.S. fishermen complained bitterly that these ships were depleting the stocks of fish, as well as the feeder fish and they were leading to the collapse of the U.S. fisheries. The federal government did little to protect this natural resource for fear of some retaliation from the two countries. This, in part, explains the lack of fish that were once abundant and the collapse of the New England fishing industry.

China, in a similar way, has continued to dump low priced goods into the U.S. and in several cases has driven out U.S. competitors with below cost pricing. This is known as predatory pricing tactics. China has been forcing companies doing business in China to give the Chinese their technology and business practices. In addition, the Chinese have stolen technology and used it to produce their own products to compete with ours. China has over built steel and aluminum factories. They have produced so much steel and aluminum that they have dumped it on the U.S. market, where U.S. producers can’t meet the low price competition. For years China has played a game with the U.S. where they export substantially more to the U.S. than what they will allow to be imported from the U.S. Companies have been complaining about this for years, but the U.S. government has done little.

The Chinese have their own agenda to have their country dominate trading. For the first time it appears that the U.S. government may address these issues in a meaningful way. We as a country have believed in fair trade and for the most part have followed such policies. Unfortunately, some of our trading partners have abused these U.S. policies. It seems that the bombast talk of escalating a trade war may deliver discussions that are long overdue.

Will a trade war ensue, will moderation save the day? Stay tuned. But as we stay tuned, the discussion of a possible trade war is creating significant market volatility.

Conclusion

We live in interesting times. Market volatility is back, and interest rates appear to be going up. We have full employment, increasing wages and company earnings are increasing. A very real measure of corporate earning power is that the price earnings ratio for forward earnings looks very strong from an investment perspective. We’ve suffered through quarters that were a lot tougher than this one. I think we got lulled by the ever gaining 2017 market and now we’re back to Market Reality 101.